Investors in Asia should think small

Investors in emerging Asia have various options, such as Chinese stocks or the smaller markets, including Hong Kong, Singapore, Taiwan, Thailand, Malaysia and South Korea.

Unless you are the kind of individual who enjoys battling governments that hold most, if not all, of the cards, option two should prove a less risky and more profitable strategy - at least for the next several months.

Chinese stock markets are cooling. After soaring 188 per cent in the year through October 16, China's CSI 300 Index has since fallen 14 per cent. The Hang Seng China Enterprises Index, consisting of mainland Chinese companies that trade in Hong Kong, has slumped 19 per cent since mid-October.

Meanwhile, China is beset with accelerating inflation and an overheated economy that expanded 11.5 per cent in the first nine months of 2007 from a year earlier. Propelled by higher energy, labour and food costs, consumer prices jumped to an 11-year peak of 6.9 per cent in November from a year earlier.

What's more, China's fragile banking system is being starved of funds by savers turned off by its low deposit rates, while investors seek to send their money abroad. Total bank deposits are growing at a record-low five per cent annual rate, while time deposits are actually contracting, according to BCA Research.

To cool economic growth, battle inflation and damp equity- market speculation, the People's Bank of China recently increased the key one-year lending rate, boosting it to a nine- year high of 7.47 per cent. It was the sixth rate increase this year.

Ten times this year, Chinese authorities have increased the reserves banks must deposit with the central bank, most recently on December 8, when they boosted the reserve requirement ratio to 14.5 per cent of deposits from 13.5 per cent, effective December 25. The ratio is the highest since at least 1987 when the data was first kept.

In a tactic specifically designed to rein in equity prices, the government has sought to mop up excess liquidity sloshing through China's economy by increasing the supply of stock. Witness PetroChina's $8.9 billion initial public offering in November and the IPO by China Shenhua Energy, which raised a similar amount in September.

The Chinese market's small free float - those shares that aren't controlled by the government and can be bought and sold by private investors - gives the state a powerful weapon in its bid to restrain equity-price increases. While the market value of the CSI 300 Index, comprising the 300 most representative stocks listed on the Shanghai and Shenzhen stock exchanges, is the equivalent of $3.06 trillion, the Chinese market's free float is just 18 per cent of that, or $554 billion, according to Morgan Stanley Capital International.

"The future release of new shares into the market, either via IPOs or by increasing the free float of state-owned shares, should prove effective in damping the stock-price bubble," says Lawrence Brainard, London-based chief economist at Trusted Sources UK, a research firm specialising in the politics and economies of Brazil, Russia, India and China.

While China policy makers have slowed the equity-market rally, they have failed to bring inflation and the economy under control. In short, so-called quantitative measures - such as raising banks' reserve requirements, imposing lending limits and prohibiting banks from making new loans - have neither slowed growth nor significantly reduced liquidity. Interest rates remain too low, the yuan's exchange rate too weak and corporate coffers are flush with retained earnings from the last few years' profit boom.

Liquidity is cascading into China through a trade surplus that Morgan Stanley projects to be $272 billion in 2007 and investment, which the firm forecasts to be $1.6 trillion.

Companies self-finance almost 60 per cent of their capital projects, compared with 45 per cent three years ago, while bank loans account for only 17 per cent of capital spending, down from 24 per cent in 2004, says Yan Wang, BCA's Montreal-based chief China strategist.

"If domestic savings continue to flood out of the banking system at this pace, bubbles in all kinds of assets around the country are likely to result, which could be very destructive to the overall stability of the economy," Wang says.

To help deflate the country's liquidity bubble, China is encouraging investment in foreign securities through its qualified domestic institutional investor, or QDII, program. As of December 12, Chinese financial institutions had received approval to invest $42.2 billion overseas, of which about $27 billion had already been invested. Market estimates put the total at $80 billion to more than $100 billion by the end of 2008. ( Gulf )